What’s the deal with tax reform?

With both the House and Senate returning from their summer recess just two weeks ago, their top priority already appears to be tax reform. Following a failed attempt at passing legislation that would modify the Affordable Care Act, or Obamacare, the Republican controlled Congress has quite the incentive to deliver on one of their top platform promise, as their credibility is on the line while voters begin to question their competency as the 2018 midterm approaches.

A poll out of the Pew Research Center shows that 72% of Americans are bothered by the complexity of the tax code while 80% do not believe corporations pay their fair share of taxes. Since the beginning of the most recent election cycle, President Trump, as well as the Republican Party as a whole, has been promising a simplification of the tax code that would include both cuts for the middle class as well as a lowering of the corporate income tax while simultaneously eliminating loopholes. But what would such a bill look like?

The U.S. tax code currently sits at over 74,000 pages, and it is no wonder firms such as H&R Block thrive by navigating it. Individual tax rates are presently split up into seven distinct tax brackets, but under Trump’s vague proposal, this number would shrink to three, including brackets at 10%, 25%, and 35%. However, these brackets can be deceiving. To understand how brackets work, let’s imagine a man named John who makes $22,000 a year, who lives in a country with three tax brackets: 0% for the first $10,000, 10% for those making up to $20,000, and 20% for those making over $20,000. While John is making more than $20,000, he does not pay a fifth of his income to the government. Instead, the first $10,000 is taxed at the lowest bracket’s rate of 0%, the next $10,000 at 10%, and only $2,000 of John’s income is taxed at 20%. This puts his effective tax rate well under 20%, despite being in the top income tax bracket. While these brackets are a bit exaggerated in comparison to the actual tax brackets, John’s theoretical income tax is important in understanding the concept of a graduated or progressive income tax.

However, income taxes are much more complex than this as the government allows what are referred to as deductions. Deductions essentially give portions of your income immunity from tax for various reasons, such as having student loans or mortgage payments. The conservative-backed simplification would most likely eliminate many of these deductions making the process much simpler. One of the major criticisms of the simplification of the tax code is that it would most likely give cuts to upper income earners. Kent Smetters, who served as an economic advisor under the George W. Bush administration points out that the top 10% of people in the United States pay about 60% of the income tax, so any form of tax cut will most likely be felt by top income earners. The exact details of the proposed personal income tax regulations have yet to be released and it is likely even after they are, there will be negotiations even before an attempt to pass it takes place.

The other main aspect of the GOP tax reform is a refurbishing of the corporate income tax. Currently, the U.S. corporate income tax stands at 35%, among the highest nominal rates in the developed world. However, due to various evasion techniques employed by large corporations, the effective corporate tax rate currently stands at around 28%, in line with similar developed nations. The verbal proposal set up by President Trump and echoed by many republicans includes a lowering of the corporate tax rate to 15% while also closing loopholes that allow companies to hide money in attempts to evade taxation. The intent it to lower the corporate tax while bringing the nominal tax rate closer to the real number. Republicans say this tax decrease would spur economic growth, but whether it will and to what extent has yet to be seen.

One of the major criticisms of decreasing the corporate tax rate is that it will only increase the U.S. national debt, which currently stands at over $20 trillion. In order to understand the relationship between the corporate tax rate and government revenue, it is helpful to look at what is known as the Laffer Curve. When the government implements a 0% tax rate, its revenue is $0 as there is no tax base. On the other side, when the government collects a 100% tax, there is no incentive for businesses to produce anything, and there is again no government revenue. However, there is a tax rate between these two extremes where the government will collect the largest amount of money. The question is just which side of the peak are we currently on? This remains up for debate, but dramatically decreasing government revenue will push the the United States further and further into debt.

In the coming weeks, Republicans are sure to push forward a tax reformation bill, even if it falls short of passing through Congress. While the primary goal of a GOP tax goal is sure to be economic growth, the Federal Reserve is also watching the economy, and if it fears rapid inflation, interest rates might rise faster than they already are projected to. This ultimately means a tax plan meant to encourage economic growth could have an opposite effect if it is too aggressive. In addition to this, any bill must be both relatively moderate to gain widespread support and revenue neutral; it cannot increase the national deficit in order to avoid the Senate filibuster rule. With their own reputation on the line, the Republican controlled Congress surely has a tall task of writing a realistic bill, and the specifics of such bill remain to be seen.